Two factors are moving the Energy sector higher. The obvious one is the higher oil price during a normally seasonally weak time. In addition, though, the market is actively looking for alternatives to IT. It isn’t that the bright long-term future for this sector has dimmed. It’s that near-term valuations for IT have risen to the point that Wall Street wants to see more concrete evidence of high growth–in the form of superior future earnings reports–before it’s willing to bid the stocks significantly higher. With IT shunted to the sidelines for now, the market is not being a picky as it might be otherwise about alternatives such as Energy and Consumer discretionary.

The fancy term for what’s going on now is “counter-trend rally.” It can go on for months.

As to the oils,

–a higher crude oil price is clearly a positive for the exploration and proudction companies that produce the stuff. In particular, all but the least adept shale oil drillers must now be making money. This is where investment activity will be centered, I think.

–refiners and marketers, who have benefitted from lower costs are now facing higher prices. So they’re net losers. Long/short investors will be reversing their positions to now be short refiners and long e&p.

–the biggest multinational integrateds are a puzzle. On the one hand, they traditionally make most of their money from finding and producing crude. On the other, they’ve spent very heavily over the past decade on mega-projects that depend for their viability on $100+ oil. This has been a horrible mistake. Shale oil output will likely keep crude well short of $100 for a very long time.

Yes, the big multinationals have all taken significant writeoffs on these ill-starred projects. But, in theory at least, writeoffs aren’t supposed to create future profits. They can only eliminate capital costs that there’s no chance of recovering. As these projects come online, they’ll likely produce strong positive cash flow (recovery of upfront costs already on the balance sheet) but little profit.

The question in my mind is how the market will value this cash flow. As I see it–value investors might argue otherwise–most stock market participants buy earnings, not cash generation. Small companies in this situation would likely be acquired by larger rivals. But the firms I’m talking about–ExxonMobil, Shell, BP…–are probably too big for that. Will they turn themselves into quasi-bonds by paying out most of this cash in dividends? I have no idea.

Two thoughts:

—–why fool around with the multinationals when the shale oil companies are clear winners?

—–as/when the integrateds start to show relative strength, we have to begin to consider that the party may be over. So watch them.

From years of analyzing oil, gas and metals mining–as well as watching agricultural commodities and high-rise real estate out of the corner of my eye–I’ve come to believe in two hard and fast rules:

–when prices begin to fall, they continue to do so until a significant amount of productive capacity becomes uneconomic and is shut down. That’s when the selling price of output won’t cover the cash cost of production. Even then, management often doesn’t reach for the shutoff valve immediately. It may hope that some external force, like a big competitor shutting down, will intervene (a miracle, in other words) to improve the situation. Nevertheless, what makes a commodity a commodity is that the selling price is determined by the cost of production.

–it’s the nature of commodities to go through boom and bust cycles, with periods of shortage/rising prices followed by over-investment that generates overcapacity/falling prices. The length of the cycle is a function of the cost of economically viable new capacity. If that means the the price of new seed that sprouts into salable goods in less than a year, the cycle will be short. If it’s $5 billion to develop a gigantic deep-water offshore hydrocarbon deposit that will last for 30 years, the cycle will be long.

boom and bust spending behavior

During a period of rising prices, cost control typically goes out the window for commodity producers. Their total focus is on adding capacity to satisfy what appears at that moment to be insatiable demand. Maybe this isn’t as short-sighted as it appears (a topic for another day). But if oil is selling for, say $100 a barrel, it’s more important to pay double or triple the normal rate for drilling rigs or mud or new workers–even if that raises your out-of-pocket costs from $40 to, say, $60 a barrel lifted out of the ground. Every barrel you don’t lift is an opportunity loss of at least $40.

When prices begin to fall, however, industry behavior toward costs shifts radically. In the case of oil and gas, some of this is involuntary. Declining profits can trigger loan covenants that require a firm to cease spending on new exploration and devote most or all cash flow to repaying debt instead.

In addition, though, at $50 a barrel, it makes sense for management to: haggle with oilfield services suppliers; do more ( or, for some firms initiate) planning of well locations, using readily available software, to optimize the flow of oil to the surface; optimize fracking techniques, again to maintain the highest flow; streamline the workforce if needed. From what I’ve read about the recent oil boom, during the period of ultra-high prices none of this was done. Hard as it may be to believe, getting better pricing for services and operating more efficiently have trimmed lifting expenses by at least a third–and cut them in half for some–for independent wildcatters in the US.

This experience is very similar to what happened in the long-distance fiber optic cable business worldwide during the turn of the century internet boom. As the stock market bubble burst and cheap capital to build more fiber optic networks dried up, companies found their engineers had built in incredibly high levels of redundancy into networks (meaning the cables could in practice carry way more traffic than management thought) and had also bought way to much of the highest-cost transmission equipment. At the same time, advances in wave division multiplexing meant that each optic fiber in the cable could carry not only one transmission but 4, or 8, or 64, or 256… The result was a swing from perceived shortage of capacity to a decade-long cable glut.

My bottom line for oil: $40 – $60 a barrel prices are here to stay. If they break out of that band, the much more likely direction is down.

There’s no easy answer to this question. I have few qualms about putting a ceiling on the oil price. In round terms, I’d say it’s $60 a barrel, since this is most likely the point at which an avalanche of new shale oil production will come on line. Also, for investing in shale oil companies this number doesn’t matter than much, so long as it’s appreciably above the current price.

A floor is harder.

a first pass through the issue

We can divide the source of oil production into three types. I’m not going to look up the numbers, but let’s say they’re all roughly equal in size:

–extremely low production cost, less than $5 a barrel, typified by production from places like Saudi Arabia

–very high production cost, like $100+ a barrel, which would be typical of exploration and production efforts of the major international oil companies over the past decade or so, and

–shale-like oil, with production costs of maybe $35 -$40 a barrel.

In practical terms, there’s never going to be an economic reason for the low-cost oil to stop flowing.

Shale oil is basically an engineering and spreadsheet exercise. The deposits are relatively small and the cost of extraction is almost all variable. So shale will switch on and off as prices dictate. We know that at the recent lows of $25 or so, all this production was shut in.

The very high production cost is the most difficult to figure out. Of, say, $100 in production expense, maybe $70 is the writeoff of exploration efforts + building elaborate hostile-environment production and delivery platforms. This is money that was spent years ago just to get oil flowing in the first place. What’s key is that for oil like this is that the out-of-pocket cost of production–money being spent today to get the oil–may be $30 a barrel. From an economic perspective, the up-front $70 a barrel should play no role in the decision to produce oil or not. So, dealing purely economically, this oil should continue to flow no matter what.

second pass

First pass says $30 – $35 a barrel is the low; $60 is the best the price gets.

Many OPEC countries (think: Saudi Arabia again) have economies that are completely dependent on oil and which are running deep government deficits. Their primary goal has to be to generate maximum revenue; the number of barrels they produce is secondary. If so, they will increase production as long as that gives them higher revenue. Their tendency will be to make a mistake on the side of producing too much, however. Their activity will make it very hard to get to a $60 price, I think.

On the other hand, shale oil producers who can make a small profit at, say, $35 a barrel may tend to shut in production at $38 – $40, on the idea that if they exercise a little patience they’ll be able to sell at $45, doubling or tripling their per barrel profit.

third pass

Second pass argues for a band between, say, $40 and $55.

Bank creditors don’t care about anything except getting their money back. They will force debtors–here we’re talking about shale oil companies–to produce flat out, regardless of price, until their loans are repaid. This was an issue last year, and what I think caused the crude price to break below $30 a barrel. I don’t think this is an issue today.

There’s a seasonal pattern to oil consumption, driven by the heating season and the driving season in the northern hemisphere. The driving season runs from April through September, the heating season from September through January. February-April is the weakest point of the year, the one that typically has the lowest prices.

If the financial press isn’t totally inaccurate, there are a bunch of what appear to be poorly -informed speculators trading crude oil. Who knows what they’re thinking?

my bottom line

This is still much more of a guessing game than I would prefer. I see three positives with shale oil companies today, however. Industry debt seems more under control. Operating costs are coming down (more on this on Monday). And seasonality should soon be providing support to prices.

Crude began to run up in early 2007. It went from $50 a barrel to a peak of around $150 in mid-2008. Recession caused the price to plunge to $30 a barrel late that year. From there it began a second, slower climb that saw it break back above $100 in early 2011. Crude meandered between $100 and $125 until mid-2014, when increasing shale oil production from the US caused supply to outstrip demand by about 1% – 2% a year. That was enough to cause a second slide, again to $30, that appears to have ended this February.

Since then, the price has rebounded to $50 a barrel, where it sits now.

To recap: $50, then $150, then $30, then $125, then $30, now $50.

Where to from here?

We know that supply remains relatively steady, with additions to output from the Middle East offsetting falls in US shale oil liftings caused by lower prices. We also know that lower prices have stimulated consumption.

The past eight years have also shown us that crude can have exaggerated reactions to small shifts in supply and/or demand. So, in one sense, no knows what the crude oil market will do next.

On the other hand, we can set some parameters.

–the first is psychological. The oil price has fallen to $30 a barrel twice in the last eight years. The first was in the depths of the worst recession since the Great Depression. The second was during a period of general market craziness earlier this year (caused, I think, by algorithms run amok). I think it’s a reasonable assumption that prices will have a difficult time getting that low again–and if they do that they won’t stay there for long.

–the second is physical, and is about shale oil. Overall shale oil output in the US is now shrinking. Firms still pumping out shale oil are of two types: companies being forced by their banks to sell oil to repay loans; and companies whose costs are low enough that they’re making a reasonable profit at today’s prices. Cash flow from the first group is by and large going to creditors, so this output will diminish as existing wells are tapped out. That’s probably happening right now, since shale oil wells typically have very short lives. This means, I think, the question about when new supply comes to market–putting a cap on prices, and perhaps causing them to weaken–comes down to when healthy shale oil firms will uncap existing, non-producing wells, and/or begin to drill new ones in large enough amounts to reverse the current output shrinkage.

I’m guessing–and that’s all it is, a guess–the magic number is $60 a barrel.

My personal conclusion, therefore, is that the crude price may still have a gentle upward bias, but that most of the bounce up from $30 is behind us.

I’m in the oil first camp. (My private opinion is that it could take a decade or more for base metal prices to perk up. Whether that turns out to be true or not is less important to a long-only investor like me than the idea that recovery is not soon.)

How so?

history

Leading with (the opposite of what you’re supposed to do) my weakest reason, look at the last cycle of gigantic investment in expanding natural resources production capacity. Oil and metals prices both peaked in 1980-81 …and then plunged. Oil stabilized and began to move up again in 1986; for metals recovery was over a decade later.

closing the supply/demand gap

There’s only a gap of a couple of percentage points between the amount of oil the world is demanding and the amount producers are willing to supply. Growth in the car industry in China, the replacement of scooters and motorcycles with cars in other high-population countries like India and the strong increase in gasoline consumption in the US now that prices are lower all argue that the shortfall between demand and supply is, little by little, being erased.

On the other hand, the extent of base metals overcapacity is less easy to put your finger on, but is, nevertheless, massive. Demand is also more cyclical–therefore less dependably growing, as well, but that’s less important than that mining capacity is added in gigantic chunks.

the nature of the enterprise

The up-front cost of a base metals mining project is very high. There’s the mine itself, the huge machines that rip the ore out of the earth and the sometimes elaborate plants that crush or grind or otherwise separate it from the ordinary dirt. Then there’s the transport link with the outside world. All of this infrastructure can lie fallow for long periods without impairing the mine’s ability to be restarted–even expanded from its prior size–very quickly.

For oil, in contrast, finding new fields is a much more important issue. Drilling new wells in an existing field is, too, in many cases. As time has passed, the focus of the big oil majors has increasingly been on mega-projects that make them look much more like base metals miners than they did when I was covering the oil industry as a securities analyst in the late 1970s – early 1980s.

Hydraulic fracturing, however, has changed the industry for good. This technology has made huge numbers of projects economically viable that have limited output that goes on for relatively short periods. This converts 21st century oil exploration, in the US at least, into a sharp-pencil engineering business that even small firms can excel at. Granted, the fact that production can turn on very rapidly when prices are high enough puts a cap on how far they can rise. But the fact that several millions of barrels of daily output can be turned off equally quickly argues that the response time of the oil industry to a supply/demand imbalance will be much quicker than has been the case in the past.

By allowing/encouraging the oil price to stay over $100 a barrel, OPEC unwittingly created a pricing umbrella that spawned a significant new, relatively high cost, shale oil industry in the US that, at its peak last year, was pumping an extra 5 million barrels of crude a day onto the world market. At that point, world supply rose above demand, with the natural consequence that prices began to fall.

The OPEC response ot lower prices has been to increase itsproduction, with the intention of spurring new demand and of forcing shale oil producers out of business. Since for most OPEC countries, oil is the principal source of GDP and of hard currency, more barrels out the door also eased revenue shortfalls somewhat. Nevertheless, OPEC is generally experiencing a significant cash squeeze.

The plan has worked, to some degree. American consumers have lost their taste for compact cars and are buying gas-guzzling trucks in huge numbers. Shale oil production is gradually fading. Overall world demand continues to rise at 1.5+ million barrels per day.

where we stand now

The excess of supply over demand is still about two million barrels per day, according to the International Energy Agency, (whose latest monthly report can be found in financial newspapaers).

The end to economic sanctions on Iran is likely to free 500,000 barrels of Persian oil for sale sometime next year, however–and that figure might be as high as a million. And China has been using the fall in prices to increase its strategic petroleum reserve. Some reports say that this process is close to an end.

storage is a key

The most important near-term factor to watch, in my view, is overall world inventories–which are at extremely high levels.

Petroleum storage is of two types:

–storage of crude, normally in tank farms, but also in rented oil tankers

–refined products storage, both in tank farms owned by refiners and (the thing we know least about) in customers’ hands–from industry to the gas tanks in individuals’ automobiles.

We do know that crude tank farms in Asia and Europe are full, and that refiners’ output storage tanks are bursting at the seams. In addition, the cost of renting a crude oil tanker to store barrels for future delivery is now higher than the profit an arbitrageur would make by buying oil now and entering a futures contract for later delivery.

On top of all that, warm weather has meant that the usual seasonal buying surge for heating oil has not yet happened.

to summarize

At the current rate of adjustment, oil supply and demand may not come into balance until late 2016–and maybe early 2017.

The world is running out of places to stash the extra crude. The globe already appears to have run out of places to do so at a profit.

Therefore, it’s possible that, at the very least, the oil price will decline again–even in a period of seasonal strength like the present–to a level where the arbitrage of buying now and storing for future delivery makes money. But when stuff like this happens, the world is rarely rational. The Goldman scenario in which the crude price falls to $20 no longer seems like a footnote. It’s something that has–I don’t know–say, a one in three chance of occurring.

If that happens, I think it would be a great chance to sift through the rubble for medium-sized US shale oil firms that will survive until better days arrive in maybe 18 months.

Last week, Goldman Sachs released a research report to clients in which it observed that if the world oil market develops in a less favorable way (to oil producers) than it currently anticipates, the crude oil price might plunge to as low as $20 a barrel before enough production is removed from the market for prices to stabilize.

This “doomsday” scenario has, naturally enough, captured all the press headlines. I haven’t seen the GS report, but I do know the factors involved. They are:

forces for price stability around $40 a barrel

Under normal conditions in a commodity market, when oversupply develops prices fall to a level below the out-of-pocket production expenses of the highest-cost producers. This eventually causes them to stop generating output. The reduction in supply stabilizes prices. If producers mothball their operations and fire their workers, that itself may be enough to start prices rising again.

Even for producers who are still profitable at lower prices, decreased cash flow leaves them less money to invest in project expansion. Price uncertainty may cause them to hesitate, as well. For those who have borrowed heavily, contracts with their lenders may force them to divert cash away from operations toward debt repayment.

forces against stability

Many members of OPEC, which accounts for about a third of world oil production, have relatively simple economies that are heavily dependent on oil to fund government spending and to provide money to ordinary citizens. Where the textbook economic response to lower prices may be to produce less, in order to maintain government plans and services (keeping citizens happy) the only response from OPEC is to produce more to generate more income. This is arguably self-defeating …and makes the problem worse. Still, OPEC has raised production by about 2 million barrels a day over the past months. And Iran is saying that once sanctions are lifted, it will begin to sell 100,000 barrels of oil a day, with presumably more in the offing.

At, say, $100 a barrel, producers of petroleum from oil sands or shale have had no pressing incentives to hone their techniques. At $40 a barrel and facing potential shutdown, they’re becoming much more inventive. So they are finding ways to lower their costs to keep delivering output to market.

oil storage

We know that the world is now being supplied with more oil than it needs because oil inventories are rising. Middlemen continue to be content to buy from producers because they can immediately sell for future delivery at a profit through derivatives and store the stuff in the mean time.

My experience is that although the markets have a rough idea of how much storage capacity there is–in giant storage tanks, barges, tanker ships…, the reality is that there’s always more capacity than the consensus suspects.

What happens when every storage container is full? …no one buys oil that comes on the market because there’s no place to put it.

the doomsday scenario

Three parts:

–shale oil producers lower their costs so that their production doesn’t fall by the 500,000 barrels/day that the market expects

–storage gets all filled up

–OPEC keeps on increasing production because it needs the money.

Middlemen turn the stuff away. Prices plummet.

probability?

I’m not worried, so I guess I think it’s low. In reality, no one knows.

Goldman has credibility in this field not only because it has strong commodity trading operations, but also because years ago it predicted $100+ per barrel oil when no one else thought it was possible.